Inflation and unemployment

Question 1

What is the Phillips curve

Answer 1

• it details the short run trade off between inflation and unemployment
• it is downwards sloping as an increase there appears to be a negative association (unemployment is high when inflation is low)

Question 2

How can the ADAS model rationalise the Phillips curve

Answer 2

• higher AD leads to higher output and higher price levels
• higher output means lower unemployment
• higher price levels means higher inflation

Question 3

What does the long run Philips curve look like

Answer 3

• it is vertical set at the natural rate of unemployment
• this is due to the classical dichotomy (real value of unemployment does not depend on nominal inflation rates in the long run)

Question 4

Why does the short run Philips curve slope downwards

Answer 4

Similarly to SRAS, the Philips curve slopes downwards only when actual inflation is different to expected inflation

Question 5

Why does monetary policy actually have any effect on output

Answer 5

• it generates unexpected inflation or disinflation
• in the long run, people will begin to expect the higher inflation and expectations will catch up
• resulting in a move up the long run Philips curve

Question 6

How do Friedman and Phelps use an equation relating to expected and actual inflation

Answer 6

U = UN - a(AI - EI)

• U = unemployment rate
• UN = natural rate of unemployment
• a = coefficient measuring how much unemployment responds to unexpected inflation
• AI = actual inflation
• EI = expected inflation

Question 7

What is a common misconception of the Philips curve

Answer 7

• it is NOT a choice between inflation or unemployment
• in reality, in the 60s, it appeared data was following a move up the Philips curve (short run); however, when people’s expectations of inflation caught up with actual inflation we saw a move up the long run Philips curve which appeared to break the trend.

Question 8

What did the oil price shocks in the 70s do

Answer 8

• put a lot of pressure on inflationary measures so policy became focused on fighting inflation
• this led to contractionary monetary policy (contracts aggregate demand)
• this causes a move down the short run Philips curve as AI<EI so higher unemployment
• eventually there was a return to natural rate of unemployment

Question 9

What is the sacrifice ratio

Answer 9

• a cost of reducing inflation
• it is the percentage points of annual output lost by reducing inflation by 1%
• typically estimated to be 3 to 5

Question 10

What are rational expectations

Answer 10

• people optimally use all information that they have when predicting the future
• if people believe that the bank will fight against inflation, they may lower expectations immediately

Question 11

What is the possibility of costless disinflation

Answer 11

Rational expectations implies a much smaller sacrifice ratio (in principle could be zero)

Question 12

What was the Thatcher disinflation

Answer 12

• peak inflation of 20% reduced to 5% in 1983
• very high unemployment (11% in 1982) and decrease in output

Question 13

How do you get people to believe the CB

Answer 13

Commit to a realistic inflation target and announce it publicly